Indexation and the Inflation Tax

by Michael R. Baye and Dan A. Black

Michael R. Baye and Dan A. Black are assistant professors of
economics at the University of Kentucky.

Executive Summary

In 1913, following the passage of the Sixteenth Amendment
to the United States Constitution, only one-half of 1 percent
of the population paid any individual income tax. The tax form
was two pages long, and it was accompanied by two pages of simple
instructions. At that time the highest marginal tax rate was
only 7 percent for those fortunate enough to earn the princely
sum of $500,000 a year, which is the equivalent today of an
annual income of over $2 million.[1]

Today, even after the tax reductions of the Economic Recovery Act of 1981, about 80 percent of the population file income
tax returns. It is not uncommon for a taxpayer to fill out 15
to 20 pages of forms, while reading several hundred pages of
IRS instructions, government publications, and privately purchased tax guides. For those families with a taxable income of
over $106,000, the marginal rate is 50 percent. In addition
the first $32,800 of wage payments are subject to the social
security (FICA) taxes, which require employers to "contribute"
7 percent and employees to "contribute" 6.7 percent of wage
income .

In addition to legislative changes in the tax code following 1913 (there have been nine revisions of the tax code since
1954), inflation has altered fundamentally the structure of the
individual income tax. During the last half of the 1970s the
inflation rate averaged 8.9 percent annually, and taxpayers
moved into higher and higher brackets as nominal incomes increased with inflation. By the end of that decade, middle class
Americans were facing marginal income tax brackets that Congress had intended for the wealthy. To combat this so-called
bracket creep, Congress in 1981 voted to index personal exemptions and rate brackets, effective in 1985, based on changes in
the Consumer Price Index (CPI) for years ending in September of
the calendar year preceding the tax year.

Recent concerns about the $200 billion budget deficit and
the inability of Congress and the Reagan administration to agree
on expenditure reductions of that magnitude have led many observers to suggest tax increases to reduce the deficit. Because
few elective officials want to be held responsible for tax increases, there has been considerable talk about eliminating the
indexation of the personal income tax that is due to begin in
1985. This measure would result in an indirect tax increase.
In addition to increasing tax revenues through the inflation
tax, the repeal of indexation would have several arbitrary
effects. By pushing more and more taxpayers into higher tax
brackets, inflation would magnify the tax distortions created
by the progressive personal income tax. In addition it would
provide an incentive for government to inflate the currency,
while most Americans prefer stable prices.

This analysis examines in some detail the effects of inflation without an indexed tax system, and it provides evidence
that the inflation tax is not a satisfactory means of raising
federal revenues. More specifically, our analysis focuses on
the history of the inflation tax and provides projections of
the inflation tax through 1990 in the event that current indexation laws are repealed.

Our evidence indicates that the inflation tax grew tenfold
during the 1970s. By 1980 the average American family needed
roughly 50 percent more income than in 1958 just to be able to
pay the inflation tax. Moreover, the inflation tax is not uniformly paid by individuals in different income classes. While
inflation pushes the poor and middle class into higher tax brackets, the wealthy remain in the 50 percent bracket. Our projections through 1990 suggest that the real tax bill of a family
with $5,000 in taxable income in 1985 will increase by 92.8
percent in just five years under an unindexed tax system and a
10 percent annual inflation rate. In contrast, the real tax
bill of a family with $200,000 in taxable income will increase
only 8.7 percent under the same conditions of five years of 10
percent inflation.